Jim McKee, director of hedge fund research at Callan Associates, believes the underperformance of hedge funds due to the one-off loss caused by the short selling ban should not be underestimated. He spoke with Amanda White about what investors should expect from hedge funds, why it’s still a manager selection game, and whether LIBOR is an appropriate benchmark.
Distilling the underperformance of hedge funds last year into component parts is a useful exercise. For one thing, says McKee, it highlights the impact made from the Securities and Exchange Commission’s September 2008 ban on short selling of the 799 financial stocks on the exchange.
“The one-time short selling squeeze driven by the regulatory ban meant that the savvy investment community playing by the rules had their rules changed and the long-only managers got a windfall. Those losses to the hedge fund community were irretrievable,” he says. “When you split it into numbers, I’d speculate that the short selling ban shouldn’t be written off as one per cent or two. It was material.”
The landscape has changed materially, however, in the past year, with the extreme capital losses from the commercial banks and investment banks paving the way for less competition over alpha.
“The environment is more attractive because there is less competition,” he says. “But risks continue, and the regulatory environment changes, for example the world governments can’t backstop their financial sector and an event could reverse the market cycle.”
With this in mind, McKee sees the investing community as remaining relatively cautious when it comes to hedge funds.
“In the wake of last year where we had everyone suffer severe damage, investors need to look at those debilitated and those capitalising on what happened.”
As such Callan believes it is still a manager selection game, which is why it is supportive of fund-of-funds. While a number of large institutions have started to shy away from fund-of-hedge funds, McKee believes they still play a useful role.
“Investors need to trust an adviser at some level to do the right thing,” he says, adding that the lost transparency from using fund-of-funds is mostly unusable.
While he says the investor won’t get the detailed transparency they would if they were holding directly, he questions if they are able to do anything with the transparency anyway.
“If you want diversification rather than manager-specific risk you should allocate to 10 or 20 or more managers but you need to devote a lot of resources to do that. It is a double edged sword to go after that transparency: the cost associated with it is not necessarily worth it,” he says.
McKee believes modest allocations to hedge funds are appropriate in light of limited alpha.
“My belief, and a common sense view, in my white papers, is there is only so much alpha out there. If you are pursuing a 20 to 30 per cent allocation then you’ll run out of alpha. It is a zero sum game at some point. About 3 per cent of capital markets allocated to hedge funds is not an inappropriate amount.”
Breaking down the attributes of the underperformance of hedge funds is also naturally useful in determining where the alpha may be, if any.
McKee believes there were some equity related losses embedded in the nature of the opportunity set, and a lot of losses can be explained by the illiquidity premium and a short-selling problem.
He points to a working paper by Yale’s Roger Ibbotson [The ABC’s of Hedge Funds, due to be updated in December and published on conexust1f.flywheelstaging.com next month], where the author determines to categorise within hedge funds how much of the return is due to alpha, and how much is in the S&P500 and the Lehman Aggregate (McKee would have personally chosen the Barclays credit not the Lehman index).
“Roger found that about 2 per cent of the return is due to alpha. Alpha is scarce, but to Roger’s credit he still said it is worth chasing,” he says.
With this in mind McKee believes that the expectations investors have about hedge funds need to be modified.
“It is still 31 flavours, everyone needs to be clear what flavours are right for them,” he says.
McKee commends Ibbotson’s approach to a composite benchmark, and says that it is misleading to cite a credit benchmark, and even more misleading an equity benchmark, as a reference for hedge funds.
“Ibbetson come up with a composite, which is fine, but it has to be an evolving one. For example in 2007, credit was a smaller component than today, and then quickly reversed. If the benchmark is evolving to reflect the underlying exposures, then that’s great,” he says.
“Conceptually the idea of a LIBOR benchmark is based on what is a trader’s ideology. Three to four times LIBOR is great, but what is four times zero? This is a work in progress for me, I’ve had 10 years to think about it.”